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Crowded Shelves Spell Slower Growth

July 31, 1994

Business Outlook: UNITED STATES

CROWDED SHELVES SPELL SLOWER GROWTH

Market players are always more interested in where the economy is going than where it has been. But when the Commerce Dept. takes a look back at last quarter's gross domestic product on July 29, including three years' worth of revisions, there might be a message about the future as well.

In general, economists expect growth to have been a shade faster in the second quarter than the 3.4% annual rate of the first quarter. But when the number comes out, check the mix. The monthly data show that overall demand, especially consumer spending, slowed sharply last quarter (chart), and the huge widening in the May trade deficit indicates that foreign trade also was a drag. At the same time, inventories piled up, accounting for a big chunk of the quarter's growth.

That combination could depress third-quarter GDP, as businesses cut back mn ordering and output in order to whittle down their stock levels. Moreover, last quarter's big bounce back in construction from the first quarter's weather-depressed building levels is not sustainable in the third quarter, in the face of rising interest rates.

No kidding. Housing starts plunged 9.8% in June, to an annual rate of 1.35 million, the lowest level since February, while permits to begin new construction fell for the second month in a row. And in July, builder surveys noted declining sales activity. Mortgage applications to buy a home dipped to their lowest level in a year and a half.

The apparent composition of second-quarter GDP, especially the slippage in demand, is further evidence that inflation will remain subdued. It also makes any immediate hike in interest rates before the Federal Reserve's Aug. 16 policy meeting, as some Fed watchers expect, difficult to justify.

Indeed, Fed Chairman Alan Greenspan suggested during his semiannual congressional testimony on monetary policy on July 20 that another rate increase was not imminent. He said that "considerable uncertainty" about future growth and price pressures was voiced at the July 5-6 policy meeting--a reason why the Fed kept rates steady. However, he also said that the Fed's near-term inflation-control efforts may not be complete, leaving the door open for another hike later on.

But if the central bank's latest forecast is on the mark, there will be little need for further tightening. The Fed sees the economy settling into "more moderate rates of growth" through 1995, with inflation remaining "relatively subdued" (table). In fact, if second-quarter growth is about as expected, the Fed's projections imply that real GDP growth in the second half will slow to somewhere between 2.6% and 3%.

Consumer spending--two-thirds of GDP--led last quarter's falloff in demand. Retail sales rose 0.6% in June, after declines in both April and May. For the quarter, inflation-adjusted sales posted only a slim gain, part of a progressive slowing since their fourth-quarter free-for-all. Based on the retail data, consumer spending labored to rise at a 1% annual rate last quarter, the weakest advance in five quarters.

Consumers appear constrained by a lack of savings, especially now that the refinancing windfall has played itself out. During the past three quarters, real consumer spending has risen at a 4.7% annual rate while real income is up only 3.4%, causing a big drop in the savings rate.

The problem for the outlook: Last quarter's consumer retrenchment fueled a steep buildup of inventories. Stock levels of manufacturers, wholesalers, and retailers jumped 1.1% in May, the biggest increase in five and a half years. Some 43% of that surge occurred at retailers, with an additional 37% at wholesalers (chart). Retail inventories soared by 1.5% in May, the largest increase in six and a half years.

Not only were June retail sales too tepid to pare down the problem, but July receipts also look weak. Sales at department and chain stores in the first two weeks of the month fell 0.9% from June, says Johnson Redbook Report.

Manufacturers continue to keep their stocks under tight control, but the inventory backup in retailing and wholesaling already appears to be curtailing some industrial activity. Industrial production at the nation's factories, mines, and utilities rose 0.5% in June, but that mainly reflected a 5.4% jump in utility output as air conditioners worked overtime in the unseasonably hot weather.

Output in manufacturing alone rose only 0.2% in June, about the same pace as in April and May, and for the quarter, production slowed considerably. Second-quarter output rose at an annual rate of 5.3%, down from a 7.8% pace in the first quarter.

A drop-off in auto and truck production accounted for much of that slowdown, but even excluding motor vehicles, June output still increased only 0.2%, about half the pace of April and May. And operating rates in manufacturing slipped to 82.8% in June, from 82.9% in May, the second dip in a row.

U.S. producers aren't the only ones adjusting to the consumer slowdown. It's a good bet that many of the goods now stacked in U.S. warehouses were made overseas. That should mitigate some of the negative side effects on the orders and output of U.S. manufacturers.

Another record level of imports caused a further deterioration in the U.S. trade deficit in May. The trade gap for all goods and services widened to $9.2 billion in May, from $8.5 billion in April, up sharply from March's $6.9 billion. Imports rose 1.2%, to $65.5 billion, while exports edged up just 0.2%, to $56.3 billion, after dropping 3.3% in April. For goods alone, the trade gap mushroomed to $14.1 billion, up from April's $13.3 billion. It was the biggest deficit since October, 1987, said the Commerce Dept. (chart).

The trade picture will probably improve in June. The influx of foreign World Cup fans boosted the U.S. travel surplus. Even so, foreign trade likely subtracted a bit from GDP growth in the second quarter.

Looking ahead, though, that drag may reverse itself. Just as American producers will have to cut back to avoid excess stockpiling, so, too, imports will probably slow to circumvent an inventory buildup of Mexican pottery, French wines, and Korean machine tools. Export growth, meanwhile, should look stronger by yearend, as recoveries in Europe buoy demand there for American-made goods.

In the past, a swing in the trade gap hasn't been as volatile as the pitch from an inventory correction. But with today's growing globalization, especially in manufacturing, foreign trade has taken on a greater importance in determining economic growth. While slower inventory building may hamper output in the second half, better trade flows should help power the expansion into 1995.JAMES C. COOPER AND KATHLEEN MADIGAN